IRA Investing: Too Much Complacency

A local talk radio host needed help last week. He was discussing the Russian invasion of Georgia and noted that the stock market didn't seem to react to what he thought was a very negative international incident. He asked for a financial analyst to call in and explain the market's action. I didn't answer his call for help, but this is only one example of market behavior that is hard to explain. Many times, news occurs that seems significant, but the market yawns. Not too surprisingly, though, the market is usually right. In the case of Georgia vs. Russia, the market seems to be right again. The crisis is unwinding with little disruption to the world economy.

Because the market is constantly discounting world events and is very efficient at doing so, I use sentiment indicators to gauge the mood of the smaller, usually uninformed investor. These measures of fear and greed are good guidelines in the attempt to forecast future market direction.

Last week, not only did the market itself seem uninterested in the Georgia invasion, but smaller investors weren't worried a bit either. On the contrary, my indicators are showing an increasing level of complacency that, if it continues, will likely turn some of my indicators negative very soon.

The difference in confidence levels between smart investors and dumb investors narrowed again last week, and this indicator slipped from bullish to neutral. Money flows into the Rydex family of funds shifted more to the bullish funds, so this important indicator remains neutral.

The only remaining bullish indicator continues to be the equity put/call ratio, but even this ratio has been deteriorating, as put buyers become less interested. I am looking at the 10-week moving average that remains in bullish territory.

The three indicators that I use to track odd-lot investor activity all remain neutral, but last week saw some serious deterioration, as odd-lot buyers became more active, while odd-lot sellers and short-sellers are backing off.

Let's look at a chart of odd-lot sales divided by odd-lot purchases.

Odd-Lot Sales & Purchases vs. the S&P 500

Click here for larger image.

This is a five-year chart of a 10-week moving average of the sales/purchases ratio, shown in red. The S&P 500 is shown in black, and the green trend lines relate to the average of the indicator and its standard deviations. The indicator has been adjusted to remove long-term trend influences.

When odd-lot investors are pessimistic and selling heavily, this ratio increases, and it is usually time to increase exposure to the stock market. On the other hand, when odd-lot purchases are high, whether due to outright buying or short-covering, a more defensive posture is warranted.

In the fall of 2007 and then again in the spring of this year, we saw extreme bearish readings for this indicator, as odd-lot investors swung to the buy side. More recently, readings have turned more neutral, but the ratio was extremely low last week, moving the 10-week average a little lower.

Similarly, odd-lot short sellers have become less active bringing that indicator to the verge of turning bearish. All of these readings mean that there is a growing sense of complacency among these smaller investors and if the market retains an upward bias for the next couple of weeks, a more cautious approach may be warranted.

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At the time of publication, Moore was long Altra Holdings, Conmed, Complete Production Services, Emcor Group, CGI Group, Integral Systems, Layne Christensen, Life Sciences Research, Open Text, Stepan, LS Starrett, Stone Energy, Sauer-Danfoss, Synnex, SPDR Trust, Sybase and U.S. Physical Therapy, although positions may change at any time.

Richard Moore, CFA, has 40 years of experience in various facets of the investment business. He has been employed by banks, mutual funds and investment advisory organizations during his career and has also owned retail and service businesses. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Moore appreciates your feedback; click here to send him an email.